What are Provisions?
Provisions represent funds put aside by a company to cover anticipated losses in the future. In other words, provision is a liability of uncertain timing and amount. Provisions are listed on a company’s balance sheet under the liabilities section.
- A provision stands for liability of uncertain time and amount.
- Provisions include warranties, income tax liabilities, future litigation fees, etc.
- They appear on a company’s balance sheet and are recognized according to certain criteria of the IFRS.
Example of a Provision
An example of a provision is a product warranty or an income tax liability.
Consider a manufacturer that offers a warranty to a customer for one of its products. The product warranty is a term in a contract, specifying the conditions under which the manufacturer will compensate for any good that is defective without any additional cost to the buyer.
That said, it falls under the definition of provision because the warranty is a possible future liability of uncertain time and amount.
How to Recognize Provisions?
Businesses cannot simply record a provision whenever they see fit. The following criteria must be met in order to recognize a provision from the perspective of the International Financial Reporting Standards (IFRS):
- An entity has a current obligation arising from past events;
- It is probable that an outflow of funds will occur during the settlement of the obligation;
- A company can make a reliable estimate of the amount of the obligation; and
- The entity will accept a particular responsibility, and other parties expect the entity to commit to its responsibilities.
Provisions are not recognized for operational costs, which are expenses that need to be incurred by an entity to operate in the future.
How to Record Provisions?
The recording of provisions occurs when a company files an expense in the income statement and, consequently, records a liability on the balance sheet. Typically, provisions are recorded as bad debt, sales allowances, or inventory obsolescence. They appear on the company’s balance sheet under the current liabilities section of the liabilities account.
What is a Loan Loss Provision?
A loan loss provision is defined as an expense set aside by a company as an allowance for any unpaid debt meaning loan repayments that are due and are not paid for by a borrower.
The loan loss provision covers a number of factors in regards to potential loan losses, such as bad debt (loans), defaults of the customers, and any loan terms being renegotiated with a borrower that will provide a lender with lower than previously estimated debt repayment amounts.
How Does a Loan Loss Provision Work?
Lending institutions, such as banks, generate a substantial portion of revenue from the interest paid by borrowers. Lenders initiate loans to a variety of clients. They include:
- Small businesses
- Large corporations, etc.
Since the 2008 Global Financial Crisis, lending regulations for banks were restricted in order to attract higher credit quality borrowers with high capital liquidity. Despite such regulatory improvements, banks still need to take into account loan defaults and the expenses for loan origination.
Loan loss provisions serve as a standardized accounting adjustment made to a bank’s loan loss reserves appearing in the lender’s financial statements. They incorporate any change in potential loss projections from the bank’s lending products due to client defaults.
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